How Cleveland Toxic Loans Ended Up in Goldman Sachs' Controversy

Eric: ideastream®'s Mhari Saito is here with me this morning to explain.

Mhari : Good morning Eric.

Eric: Just to quickly recap, Goldman Sachs is in trouble for this investment because essentially they are accused of not owning up to investors how bad the deal was?

Mhari: Right, a hedge fund called Paulson and Co basically handpicked mortgage-backed securities that they thought would go bad. Paulson is not in trouble, but Goldman Sachs is because it allegedly didn't tell investors that Paulson was betting that the investment vehicle would lose a ton of money.

Eric: So how do Cleveland-area mortgages fit into this?

Mhari: Let's start with one homeowner:

Erline Heard:My name is Erline Heard and I bought 8 houses in 2006.

Mhari: I met 39-year-old Erline Heard at her apartment on the east side of Cleveland. She says she got into real estate after a conversation with her best friend's boyfriend, a mortgage broker named Mark Kellogg. He told her buying houses, fixing them up and flipping them was easy.

Erline Heard: I'm thinking that this was something that was going to progress into a nice livelihood, a nice lifestyle, just by buying these houses, flipping them and selling them on the market. I mean I see the shows on the TV all the time...so... I just thought that I was going to get a piece of that pie.

Mhari: Erline though had terrible credit. She'd tried to buy a house before and been denied. She'd just gotten a $10 an hour clerical job. She says she was shocked when the deals came through.

Erline: I only had that job for a couple months before I signed for the houses. I had to have some source of income. I didn't know, this guy just exaggerated my income. I mean totally exaggerated.

Eric: Who is 'This guy?'

Mhari: The mortgage broker. Mark Kellogg and Erline Heard have pleaded guilty to faking her income on loan applications. They are part of a fraud scam that took out chunks of Cleveland's Slavic Village neighborhood. Erline and 11 other buyers like her have pleaded guilty and been sentenced, mostly to probation. The broker, Kellogg, is being sentenced later this month.

Eric: And were loans made by these characters packaged with loans that were sold on Wall Street?

Mhari: Yes.Three of Erline Heard's mortgages were bundled into a mortgage-backed security called Long Beach Mortgage Loan Trust 2006-4. This security was one of 90 referenced in the now infamous Goldman Sachs investment called ABACUS.

Eric: OK, so if we go back to what you were saying earlier, essentially, the hedge fund, Paulson and Co was betting that ABACUS, this investment would go bad. That Cleveland-area borrowers like Erline Heard would go into foreclosure.

Mhari: Yes. The Wall Street Journal says nearly half of the 500,000 loans from all across the country referred to in the deal went bad and Paulson made a billion dollars.

Eric: Who bought the investment?

Mhari: According to the SEC, a bank in Germany called IKB did. The Royal Bank of Scotland was also a partner in the deal. As Abacus went bad, both banks had to be bailed out by taxpayers in their countries. And, back to the story we've all heard, Goldman Sachs says it did nothing wrong.

Eric: And you found other Cleveland-area mortgages related to fraud cases tied to the Goldman Sachs deal?

Mhari: Yes, nearly 50. Most of them are in the city of Cleveland. And to be clear, Goldman Sachs had nothing to do with how these loans were written.THere's a reason for that which I learned from Kathleen Engel, a law professor at Suffolk University. It's to protect the people who are selling these securities from getting into trouble.

Kathleen Engel: The structure is to insulate everyone in the middle - the lenders, the investment banks, the rating agencies and It's unlikely the underwriters would have any specific knowledge of fraud. They set it up so they couldn't know. They didn't want to know because knowledge equals liability.

Mhari: But Cleveland City Law Director Robert Triozzi says Wall Street created the market and needs to be held accountable.

Cleveland City Law Director Robert Triozzi: While they played their games, a community like Cleveland had to suffer the harm for it. As they walk away with their profits and their losses we are left holding the bag, having to deal with all these vacant and abandoned properties.

Eric: That brings us back to what I mentioned in the intro, the city's lawsuit against Wall Street investment banks.

Mhari: Right, the lawsuit was dismissed last year, there was an appeal heard in federal court here earlier this month. The city's attorney did not sound optimistic, but there are other related cases still pending in other courts.